How a Wildly Successful Fund Demonstrates the Risk of Active Management

A few months ago a friend and I were engaged in a friendly debate regarding the merits of actively managed funds. My friend is an indexing skeptic, firm in his belief -- if not always brimming with evidence -- that he is capable of identifying tomorrow's winning equity funds.

One of the funds he offered as proof of the wisdom of his approach was the Fairholme fund. There's not denying Fairholme's track record. Over the past ten years, the fund has earned an average annual return of 10.4 percent, outperforming both the S&P 500's 2.9 percent return and 99 percent of all other funds in its category. The fund's manager, Bruce Berkowitz, has earned that record via a series of well-timed, concentrated bets that demonstrated both his willingness to go against the crowd and a strong belief in his convictions.

The fund has been so successful, in fact, that Morningstar almost can't find enough awards for Berkowitz. He was named domestic equity manager of the year in 2009 and manager of the decade just a year later.

Given that track record, you might imagine my friend's surprise when I argued that the Fairholme fund was, in my opinion, Exhibit A in the case against active management.

In my opinion, one of the greatest risks of actively managed funds is the uncertainty that accompanies them. It's nearly impossible to separate the lucky fund managers from those who are truly skilled. And even worse, it's exceedingly difficult to try to discern when a manager's luck (or skill) has run out, and it's time to exit the fund. The problem, obviously, is that's a vitally important decision. Give up on a manager too early and you'll miss out on superior performance; hang on too long and you'll suffer lousy returns relative to the market.

And therein lies the dilemma of actively managed funds. When we look back at a manager's superior record, it looks like it was all sweetness and light, with the shareholders happily coasting along on their way to riches. What's not apparent in looking at return figures are the inevitable ups and downs that occurred along the way; the gut-wrenching short-term lags that left investors questioning their decision and, in many cases, bailing out.

Fairholme's recent performance is a fine example of this dilemma. That stellar ten-year record hides rather lousy near-term performance. Over the past 12 months the fund has earned a 15.3 percent annual return -- less than half the 33 percent return provided by the S&P 500. For the year-to-date, the fund's return is -8.0 percent, versus the S&P's 7.6 percent. Both figures rank in the bottom percentile of its category.

That performance is largely attributable to the fund's heavy exposure to the financial sector, which accounts for nearly 75 percent of the portfolio. Berkowitz is betting that his assessment on firms like AIG and Bank of America is more accurate than the overall market's.

Who will eventually be proven correct? It's impossible to tell right now. Berkowitz and his believers can point to his past record as proof that a little patience is due. But on the other hand, Berkowitz would be far from the first star manager to find that his magic touch has abandoned him and a long stretch of inferior performance is looming (see Miller, Bill).

If that kind of uncertainty and constant second-guessing appeals to you, perhaps you're cut out for the buy-and-hope approach that investors in actively managed funds must adopt. But for my money, there's no question that there's more than enough uncertainty in the markets themselves, and I don't need to add an additional layer on top of that to indulge the faint hope that I'll catch lightning in a bottle. But to each his own.

View all articles by Nathan Hale on CBS MoneyWatch »
Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.